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There’s another reason why growth companies borrow less. Their growth opportunities are
real options, that is, options to invest in real assets. The options contain lots of hidden finan-
cial risk. We will see in Chapters 20 through 22 that an option to buy a real asset is equivalent
to a claim on a fraction of the asset’s value, minus an implicit debt obligation. The implicit
debt obligation is usually larger than the net value of the option itself.
A growth company therefore bears financial risk even if it does not borrow a dime expli-
citly. It makes sense for such a company to offset the financial risk created by growth options
by reducing the amount of debt on its balance sheet. The implicit debt in its growth options
ends up displacing explicit debt.
Growth options are less important for mature corporations. Such companies can and usu-
ally do borrow more. They often end up following the pecking order. Information problems
deter large equity issues, so such firms prefer to finance investment with retained earnings.
They issue more debt when investments outrun retained earnings, and pay down debt when
earnings outpace investment.
Sooner or later a corporation’s operations age to the point where growth opportunities
evaporate. In that case, the firm may issue large amounts of debt and retire equity, to constrain
investment and force payout of cash to investors. The higher debt ratio may come voluntarily
or be forced by a takeover.
These examples are not exhaustive, but they give some flavor of how a thoughtful CEO can
set financing strategy.● ● ● ● ●
FINANCE IN PRACTICE
❱ In 2006, Ford Motor Company brought in a new
CEO, Alan Mulally, who launched a thorough restruc-
turing of the company. The company had to cut costs,
improve efficiency, and renew its products. This
involved a massive investment, but debt financing was
available. The company decided to borrow as much as it
could, to maximize the amount of cash on hand to pay
for the restructuring.
In December 2006, Ford issued $5 billion of senior
convertible notes. It also arranged a $7 billion, seven-
year term loan and an $11.5 billion, five-year revolving
credit facility. The total was $23.5 billion.
Ford was able to get this money by pledging almost
all of its assets as collateral, including its U.S. property,
plant, and equipment; its equity investments in Ford
Credit and Ford’s foreign subsidiaries; and its trade-
marks, including the Ford brand name and logo.
Why did Ford decide to use up all of its financial
slack in one gigantic gulp? First, debt financing was
available on relatively easy terms in 2006. Second,
Mulally must have been aware of the history of restruc-
turing programs in the U.S. auto industry. Some of
these initiatives were failures, some partial successes,
but none solved Ford, GM, or Chrysler’s competitive
problems. The companies shrank but did not improve
sig n i f ica nt ly.
So Mulally was in effect sending a wake-up call
to Ford’s managers and employees: “We’ve raised
all the cash that we can get. This is our last chance
to reform the company. If we don’t make it, Ford is
gone.”
Ford did not follow GM and Chrysler into bank-
ruptcy. It lost money in the recession of 2008, but then
recovered quickly. It looks as if Ford is a survivor.Ford Cashes in All of its Financial Slack